Reflections on Trade: Part I

Donald Trump ran on a platform opposing free trade. Although Congressional support for free trade has been waning for some time, the general consensus among economists is that free trade makes the economy more efficient and supports global stability.

However, the steady erosion of manufacturing jobs in the U.S. and the shrinking of the middle class1 have called the consensus view into question. It is clear that President Trump’s anti-trade rhetoric resonated with voters and was one of the factors that led to his election.

Since the election, there have been a number of assertions made about trade, both positive and negative, that appear to us to be only partially true and perhaps designed to support a particular position. Trade can be negative for participants facing competition from abroad; for the overall economy, it does seem to bring more variety and lower prices.

In this multi-part report, we will offer several reflections on trade that we hope can provide some insight into how to use macroeconomics to judge the veracity of certain claims. It is our goal to present a fair reading of economic theory that will help readers make sense of what the media reports. This topic is worthy of a geopolitical report because American trade policy has been a critical element in how the U.S. manages its superpower role. In Part I, we will lay out the basic macroeconomics of trade. In Part II, we will discuss the impact of exchange rates and further examine the two models of economic development. Part III will analyze the reserve currency’s effect on trade. Part IV will look at some real world examples and conclude with market ramifications.

Are imports a drag on growth?
The current administration has made the assertion that imports are a drag on growth, which comes primarily from Peter Navarro, the Director of the White House National Trade Council. Strictly speaking, it is correct. In national income accounting, imports are subtracted from GDP. The reason for subtracting imports from the calculation is to avoid double counting.

Gross domestic product (GDP) is the sum of consumption ©, investment (I), government consumption (G) and net exports (X-M), or:

GDP = C + I + G + (X-M)

One way to think about GDP is that it is the sum of all things produced inside a nation’s borders. Thus, all things produced must fall into the above equation’s components—in other words, everything produced is either consumed by households, represents investment for firms, consumed by the government or consumed by foreigners via exports. If imports are not subtracted, it would overstate GDP, which, to reiterate, is domestic production within a nation. Imports are not produced within a nation.

Another way to think about imports is that all imports are consumed in some fashion. They are bought by households, firms, the government or re-exported. Thus, they are already counted in the GDP equation.

Although imports do reduce GDP, they are not necessarily a measure of “loss.” A nation may import some goods that are not produced at home and thus blocking these goods doesn’t improve the wellbeing of a nation. Additionally, even if the good is produced at home, comparative advantage2 may mean we are better off importing the good anyway. In some cases, imported goods allow a nation to boost overall output; importing capital goods to build productive capacity or raw materials to produce finished goods are examples of beneficial imports. At the same time, there are cases where imports do adversely affect domestic industries and jobs. However, we believe it’s better to examine this issue in a broader context. If imports were inherently bad, then the world’s most obvious autarky, North Korea, should be the most prosperous nation on earth. That would be a difficult position to defend.

Is mercantilism viable?
Mercantilism is the trade theory that suggests a nation is strengthened to the degree that it runs a trade surplus and accumulates foreign reserves, usually in the form of precious metals. This is an old theory that was disproven by David Hume in 1752 in his analysis of the price-specie flow mechanism. Essentially, Hume argued that if a nation accumulated gold by exporting more goods than it imported, the money supply would rise and cause price levels to rise. As price levels increased, foreign goods would become more attractive in price and lead to a reversal of the flows. If trade barriers prevented the reversal of precious metals flows, the overall outcome would simply be inflation. A good example is colonial era Spain, which captured enormous amounts of precious metals from its colonies in the Americas. The accumulation of silver and gold reportedly bolstered the trend toward higher prices.3

Despite this analysis, politicians since the 18th century have still supported what are essentially mercantilist trade policies. Initially, the thought was that large government coffers of gold would give a nation the resources to fight wars and thus was a form of defense spending. In logic, this is known as the error of composition. This classic error is the mistaken belief that what holds for the individual is true for the entirety. There is a natural human tendency to see saving as an individual virtue and mercantilism appears to be a form of saving. If it’s an individual virtue, it “must” be a collective one as well. As Hume noted, not necessarily.